Saudi Arabia: Turbulence on the Horizon?

There is considerable change underway in Saudi Arabia, from how the country is governed and managed to an even more activist role in the politics of the volatile Middle East. Options markets, however, appear to be almost entirely unconcerned about recent developments in the country, the world’s largest exporter of crude oil and a key U.S. ally in the Middle East.

At-the-money implied volatility on West Texas Intermediate (WTI) Crude Oil options has been trading near its lowest point since late 2014 and is well below its long-term average. For example, on November 17, 90-day WTI options closed at 23% implied volatility, well below their 31% average so far this decade (Figure 1). Are markets too complacent in the face of potential political disruption in Saudi Arabia and its neighboring countries.

Figure 1: Whistling Past the Graveyard or Rightfully Unconcerned?

Several events have occurred since November 4 that should be of concern to the oil market:

Crown Price Mohammed bin Salman, commonly referred to by his initials MBS, decreed the creation of an anti-corruption committee.

11 Saudi princes, including billionaire investor Alwaleed bin Talal, four cabinet ministers, dozens of former government officials and 500 others have been arrested on charges including embezzlement, bribery and extortion.

Hundreds of bank accounts have been frozen as part of the investigation.

On the same day, Prince Mansour bin Muqrin bin Abdul Aziz, the son of the former Crown Price and intelligence chief, Prince Muqrin bin Abdulaziz, died in a helicopter crash 70 miles north of the border with Yemen, an event the family described as "an accident." King Salman, who is in poor health, pushed aside Prince Muqrin from the line of succession in April 2015 in favor of Prince Mohammed bin Nayef, an interior minister, who was in turn ousted in June 2017 by King Salman in favor of his son, the current Crown Prince.

Lebanese Prime Minister Saad Hariri, who was visiting Saudi Arabia on the day of the arrests, resigned as prime minister in a televised announcement from the Saudi capital of Riyadh and is yet to return home as of this writing.

Also on November 4, Saudi forces intercepted a missile allegedly of Iranian origin fired at the Riyadh by Yemeni rebels. Saudi Arabia accused Iran of "an act of war."

Saudi Arabia ordered its citizens out of Lebanon.

The President of the United States tweeted his support for the actions of the Saudi Crown Prince.

These events took place in a broader context of an ambitious reform program, designed to reduce Saudi dependence on oil over the long term, buy time in the short run for a successful initial public offering of state oil behemoth Aramco, to curtail the power of Wahhabism and the religious police (by giving women the right to drive, for example,) and to promote a more assertive foreign policy to contain Iranian ambitions in the region. The new foreign policy also means isolating Qatar, with whom the Saudis cut off diplomatic relations in July, and aggressively fighting Iranian-backed Houthi forces in Yemen. One must wonder if the Saudi Crown Prince has bitten off more than he and his allies can chew.

While oil prices rose a few dollars amid these events, options markets have shown little reaction. There are a number of possible reasons for the market’s nonchalance:

Market participants apparently view Saudi Arabia and the Middle East as being relatively stable despite the recent events.

The rebound in U.S. oil production may also be reducing volatility by diversifying the world’s supplies of oil, offsetting potential Middle East supply volatility.

For oil markets, the recent events are a double-edged sword. On the one hand, if events in Saudi Arabia spiral out of control or if conflict breaks out with Iran, prices could soar. On the other hand, heightened tensions could encourage Iran and its allies, including Iraq, to pump more oil, allowing production cuts by the Organization of Petroleum Exporting Countries (OPEC) to fade and for prices to fall.

Inventories: although they have begun to decline, they remain at high levels and could temporarily buffer any supply disruptions.

A low level of realized volatility makes it too expensive to maintain long positions in options.

Still, one must wonder if markets are approaching these recent developments with a high degree of complacency. There are three reasons for this concern.

First, while the Saudi Crown Prince appears to be firmly in control of the kingdom at the moment, he has taken on such an ambitious program that he risks encountering a backlash. This is of even greater concern since he is not yet King. Even if he were King, he still might not be immune to forces pushing back against his modernizing agenda. Viewing recent events, it’s hard not to be reminded of the events of March 25, 1975, when Faisal bin Musaid assassinated his uncle King Faisal bin Abdulaziz. One of King Faisal’s alleged sins, in the eyes of his detractors, was modernization. He introduced the television to Saudi homes, a move which provoked violent protests by religious hard liners. The person who led those protests was none other than his immediate successor, the future King Khalid.

It is difficult to evaluate the likelihood of an analogous event or different form of backlash today but, if it did occur, it would have the potential to create turmoil in a country where half the population is below the age of 25, many young people lack employment and crave additional freedoms. Moreover, reducing the power of the Sunni-Wahhabist religious police, whatever its other merits, has the potential to destabilize the heavily Shiite regions which produce nearly all of the country’s oil. Despite the wealth of oil, the Shiite majority in the Saudi Arabia’s oil-rich regions live in relative poverty and may see any pull back by the religious police as an opportunity to push back against control by Riyadh.

Secondly, how will the recent wave of arrests impact Aramco’s impending initial public offering? Even prior to the recent wave of arrests, potential investors in Aramco were probably wondering about its corporate governance and the rights of minority stakeholders in an organization deeply intertwined with the Saudi state and royal family. The events outlined above might deepen concerns regarding property rights and due process of law, potentially reducing the price that investors are willing to pay for Aramco’s shares.

Finally, the idea that U.S. production might offset any reduction in Middle East supply is looking less certain than it was a few months ago. Over the past year, increased U.S. production has largely offset reduced production from OPEC. Since this summer, however, U.S. production appears to have hit a wall. Rig counts have stopped increasing and production growth has stalled close to its previous record high (Figure 2).

Figure 2: Has U.S. Production Hit a Short-Term Wall?

This situation could change if prices continue to rise, incentivizing additional production. Indeed, the International Energy Agency forecasts a surge in U.S. production by 2025 that could solidify the country’s status as the global swing producer. Even so, how quickly such supplies could be brought on line is not obvious. Typically, a surge in prices takes at least a few weeks or months to begin incentivizing the deployment of additional equipment. Once that equipment is in place, its primary impact upon oil production doesn’t occur for another four months. In short, if something big happens in the Middle East, the U.S. may take six months or more to begin compensating for any lost supplies.

If things take a wrong turn in Saudi Arabia, it won’t be bad news for everybody. Oil producers outside of the Middle East, including those in the U.S., Russia, Venezuela and Africa would stand to benefit. The primary losers would be oil consumers, especially in places like Europe, South Korea and Japan that produce little in the way of their own oil. A Middle East supply disruption could also benefit holders of energy sectors stocks at the expense of holders of most other equity sectors.

Bottom Line

Options markets appear to be relatively unconcerned by recent developments in Saudi Arabia.

The recent developments could prove to be neutral, bullish or bearish for oil, depending on what happens next in Saudi Arabia.

The Saudi Crown Prince has commenced an ambitious agenda full of risks by simultaneously cracking down on corruption, curtailing the religious police, reforming the economy, attempting to opening up Aramco and taking a more aggressive stance against Iran, Qatar, Yemeni rebels and Hezbollah all at once.

Oil options may be highly complacent.

U.S. production may not be able to rise quickly enough in the event the situation turns sour in Saudi Arabia.

The winners of any Middle East supply disruption include Russian, U.S., Venezuelan and African oil producers and energy stocks.

The losers include oil consumers, especially in non-oil producing nations, and most other non-energy equity sectors.

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

About the Author

Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.

Saudi Arabia & WTI Crude Oil

Saudi Arabia, the world's top oil exporter, has embarked on an ambitious and controversial plan to reduce its dependence on fossil fuels while eradicating corruption. How will this plan impact the global oil market and the country's proposed initial public offering of state-owned Aramco? Hedge against the uncertainty with CME Group's suite of Energy futures and options.

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